Severn Trent (LON:SVT) May Have Issues Allocating Its Capital

If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding base of capital employed. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. Having said that, from a first glance at Severn Trent (LON:SVT) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.

Understanding Return On Capital Employed (ROCE)

If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. Analysts use this formula to calculate it for Severn Trent:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

0.043 = UK£494m ÷ (UK£13b - UK£1.3b) (Based on the trailing twelve months to September 2023).

Thus, Severn Trent has an ROCE of 4.3%. On its own that's a low return on capital but it's in line with the industry's average returns of 4.1%.

Check out our latest analysis for Severn Trent

In the above chart we have measured Severn Trent's prior ROCE against its prior performance, but the future is arguably more important. If you'd like, you can check out the forecasts from the analysts covering Severn Trent here for free.

The Trend Of ROCE

When we looked at the ROCE trend at Severn Trent, we didn't gain much confidence. To be more specific, ROCE has fallen from 6.1% over the last five years. Although, given both revenue and the amount of assets employed in the business have increased, it could suggest the company is investing in growth, and the extra capital has led to a short-term reduction in ROCE. If these investments prove successful, this can bode very well for long term stock performance.

The Bottom Line

In summary, despite lower returns in the short term, we're encouraged to see that Severn Trent is reinvesting for growth and has higher sales as a result. Furthermore the stock has climbed 65% over the last five years, it would appear that investors are upbeat about the future. So while the underlying trends could already be accounted for by investors, we still think this stock is worth looking into further.

One final note, you should learn about the 4 warning signs we've spotted with Severn Trent (including 2 which shouldn't be ignored) .

While Severn Trent isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.